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Taxation of Private Companies: The Future of Surplus Stripping

On July 18th the Liberal Government introduced a consultation paper, “Tax Planning Using Private Corporations” (the “Paper”). The Paper addressed issues relating to income sprinkling, multiplication of the capital gains exemption, conversion of income to capital gains and the taxation of passive income.

In our previous posts, we summarized the key points arising out of the October 16th and October 18th announcements concerning the Government’s changes to the taxation of private companies. The purpose of this post is to report on the Government’s direction as to the conversion of income to capital gains or what is referred to as surplus stripping.

On October 19th, Finance Minister Bill Morneau and Minister of Agriculture and Agri-Food Lawrence MacAuley announced in Erinsville, Ontario that the Government will not be moving forward with measures to address the conversion of income into capital gains or surplus stripping. In the October 24, 2017 Economic Statement, the Government confirmed that it will not be proceeding with the draft legislation including the effective date of July 18, 2017.

Two anti-surplus stripping provisions were included in the draft legislation released on July 18th with effect on that date (as opposed to January 1, 2018 in every other case). These changes were among the most troublesome.

One of the proposed amendments had the effect of increasing the tax consequences arising as a result of the death of a private company shareholder from either 23.85% or 31.30/40.61 to 55.15% or 64.46% (the difference being whether a dividend would be subject to tax as an eligible or ordinary dividend). Most concerning was that this change was to take immediate effect. It affected planning in process for estates where a shareholder had died before July 18th.

This same provision would also have increased substantially the tax cost of transferring shares of a private company to a family member.

The second proposed amendment had the effect of converting distributions from a company to a shareholder to an ordinary dividend and, in some circumstances, reducing permanently the capital dividend account from which tax-free distributions can be made. The provision was framed in very broad terms and as a result, it was unclear whether many payments of funds by a company to an individual would be affected — including payments of promissory notes that were outstanding before July 18th.

The fact that the government is not moving forward with these measures at this time is good news. However, we know that the Department of Finance remains firm in its belief that changes are required. This is consistent with the Finance Minister’s statement that they are “stepping back” and that the government will embark on a year of consultation aimed at developing new proposals to accommodate intergenerational transfers while protecting the fairness of the tax system.